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Life Insurance Tips

Lifeinsurance is a contract between the policy owner and the insurer,where the insurer agrees to pay a sum of money upon the occurrence ofthe insured's death.

In return, the policyowner (or policy payor) agrees to pay a stipulatedamount called a premium at regular intervals.

Last Updated -27th September 2006

Costs, insurability, and underwriting

• The insurer (the life insurance company) calculates the policy priceswith an intent to recover claims to be paid and administrative costs,and to make a profit. The cost of insurance is determined using mortalitytables calculated by actuaries. Actuaries are professionals who useactuarial science which is based in mathematics (primarily probabilityand statistics). Mortality tables are statistically based tables showingaverage life expectancies. The three main variables in a mortality tableare age, gender, and use of tobacco. The mortality tables provide abaseline for the cost of insurance. In practice, these mortality tablesare used in conjunction with the health and family history of the individualapplying for a policy in order to determine premiums and insurability.The current mortality table being used by life insurance companies inthe United States and their regulators was calculated during the 1980s.There is currently a measure being pushed to update the mortality tablesby 2006.
• The current mortality table assumes that roughly 2 in 1,000 peopleaged 25 will die during the term of coverage. This number rises roughlyquadratically to about 25 in 1,000 people for those aged 65. So in agroup of one thousand 25 year old males with a $100,000 policy, a lifeinsurance company would have to, at the minimum, collect $200 a yearfrom each of the thousand people to cover the expected claims.
• The insurance company receives the premiums from the policy ownerand invests them to create a pool of money from which to pay claims,and finance the insurance company's operations. Contrary to popularbelief, the majority of the money that insurance companies make comesdirectly from premiums paid, as money gained through investment of premiumswill never, in even the most ideal market conditions, vest enough moneyper year to pay out claims. Rates charged for life insurance increasewith the insured's age because, statistically, people are more likelyto die as they get older.
• Since adverse selection can have a negative impact on the financialresults of the insurer, the insurer investigates each proposed insured(unless the policy is below a company-established minimum amount) beginningwith the application, which becomes part of the policy. Group Insurancepolicies are an exception.
• This investigation and resulting evaluation of the risk is calledunderwriting. Health and lifestyle questions are asked, and the answersare dutifully recorded. Certain responses by the insured will be givenfurther investigation. Life insurance companies in the United Statessupport The Medical Information Bureau, which is a clearinghouse ofmedical information on all persons who have ever applied for life insurance.As part of the application, the insurer receives permission to obtaininformation from the proposed insured's physicians.
• Life insurance companies are never required by law to underwrite orto provide coverage on anyone. They alone determine insurability, andsome people, for their own health or lifestyle reasons, are uninsurable.The policy can be declined (turned down) or rated. Rating means increasingthe premiums to provide for additional risks relative to that particularinsured.
• Many companies use four general health categories for those evaluatedfor a life insurance policy. These categories are Preferred Best, Preferred,Standard, and Tobacco. Preferred Best means that the proposed insuredhas no adverse medical history, is not under medication for any condition,and his family (immediate and extended) have no history of early cancer,diabetes, or other conditions. Preferred is like Preferred Best, butit allows that the proposed insured is currently under medication forthe condition and may have some family history. Most people are in theStandard category. Profession, travel, and lifestyle also factor intonot only which category the proposed insured falls, but also whetherthe proposed insured will be denied a policy. For example, a personwho would otherwise be in the Preferred Best category will be denieda policy if he or she travels to a high risk country.

Death proceeds

• Upon the death of the insured, the insurer will require acceptableproof of death before paying the claim. The normal minimum proof isa death certificate and the insurer's claim form completed, signed,and often notarized. If the insured's death was suspicious and the policyamount warrants it, the insurer may investigate the circumstances surroundingthe death, before deciding whether there is a legal obligation to paythe claim.
• Proceeds from the policy may be paid in a lump sum or as an annuitypaid over time in regular recurring payments for either for the lifeof a specified person or a specified time period.

Types of life insurance

Life insurance may be divided into two basic classes – temporaryand permanent.

• Temporary - This type of insurance is characterized by itsdefined time period that is named when the contract is initially putinto force. In the case of annual renewable term (ART), this is notthe case. This is due to the fact that coverage is provided for oneyear.
• Permanent - Permanent life insurance is life insurance thatremains in force until the policy matures (pays out), unless the ownerfails to pay the premium when due (the policy expires). The policy cannotbe cancelled by the insurer for any reason except fraud in the application,and that cancellation must occur within a period of time defined bylaw (usually two years). Permanent insurance builds a cash value thatreduces the amount at risk to the insurance company and thus the insuranceexpense over time. This means that a policy with a million dollars facevalue can be relatively inexpensive to a 70 year old because the actualamount of insurance purchased is much less than one million dollars.The owner can access the money in the cash value by withdrawing money,borrowing the cash value, or surrendering the policy and receiving thesurrender value. The three basic types of permanent insurance are wholelife, universal life, and endowment.
  • Whole life coverage - Whole life insurance provides fora level premium, and a cash value table included in the policy guaranteedby the company. The primary advantages of whole life are guaranteeddeath benefits, guaranteed cash values, fixed and known annual premiums,and mortality and expense charges will not reduce the cash valueshown in the policy. The primary disadvantages of whole life arepremium inflexibility, and the internal rate of return in the policymay not be competitive with other savings alternatives. Riders areavailable that can allow one to increase the death benefit by payingadditional premium. The death benefit can also be increased throughthe use of policy dividends. Premiums are much higher than terminsurance in the short-term, but cumulative premiums are roughlyequivalent if policies are kept in force until average life expectancy.Cash value can be accessed at any time through policy "loans".Since these loans decrease the death benefit if not paid back, paybackis optional. Cash values are not paid to the beneficiary upon thedeath of the insured; the beneficiary receives the death benefitonly.
  • Universal life coverage - Universal life insurance (UL)is a relatively new insurance product intended to provide permanentinsurance coverage with greater flexibility in premium payment andthe potential for a higher internal rate of return. A universallife policy includes a cash account. Premiums increase the cashaccount. Interest is paid within the policy (credited) on the accountat a rate specified by the company. This rate has a guaranteed minimumbut usually is higher than that minimum. Mortality charges and administrativecosts are charged against (reduce) the cash account. The surrendervalue of the policy is the amount remaining in the cash accountless applicable surrender charges, if any.
  • With all life insurance, there are basically two functions thatmake it work. There's a mortality function and a cash function.The mortality function would be the classical notion of poolingrisk where the premiums paid by everybody else would cover the deathbenefit for the one or two who will die for a given period of time.The cash function inherent in all life insurance says that if aperson is to reach age 95 to 100 (the age varies depending on stateand company), then the policy matures and endows the face valueof the policy.
  • Actuarially, it is reasoned that out of a group of 1000 people,if even 10 of them live to age 95, then the mortality function alonewill not be able to cover the cash function. So in order to coverthe cash function, a minimum rate of investment return on the premiumswill be required in the event that a policy matures.
  • Universal life policies guarantees, to some extent, the deathproceeds, but not the cash function - thus the flexible premiumsand interest returns. If interest rates are high, then the dividendshelp reduce premiums. If interest rates are low, then the customerwould have to pay additional premiums in order to keep the policyin force. When interest rates are above the minimum required, thenthe customer has the flexibility to pay less as investment returnscover the remainder to keep the policy in force.
  • The universal life policy addresses the perceived disadvantagesof whole life. Premiums are flexible. The internal rate of returnis usually higher because it moves with the financial markets. Mortalitycosts and administrative charges are known. And cash value may beconsidered more easily attainable because the owner can discontinuepremiums if the cash value allows it. And universal life has a moreflexible death benefit because the owner can select one of two deathbenefit options, Option A and Option B.
  • Option A pays the face amount at death as it's designed to havethe cash value equal the death benefit at age 95. Option B paysthe face amount plus the cash value, as it's designed to increasethe net death benefit as cash values accumulate. Option B does carrywith it a caveat. This caveat is that in order for the policy tokeep its tax favored life insurance status, it must stay withina corridor specified by state and federal laws that prevent abusessuch as attaching a million dollars in cash value to a two dollarinsurance policy. The interesting part about this corridor is thatfor those people who can make it to age 95-100, this corridor requirementgoes away and your cash value can equal exactly the face amountof insurance. If this corridor is ever violated, then the universallife policy will be treated as, and in effect turn into, a ModifiedEndowment Contract (or more commonly referred to as a MEC).
  • But universal life has its own disadvantages which stem primarilyfrom this flexibility. The policy lacks the fundamental guaranteethat the policy will be in force unless sufficient premiums havebeen paid and cash values are not guaranteed.
  • Universal life policies are sometimes erroneously referred toas self-sustaining policies. In the 1980s, when interest rates werehigh, the cash value accumulated at a more accelerated rate, anduniversal life coverage was often sold by agents as a policy thatcould be self-paying. Many policies did sustain themselves for aprolonged period, but the combination of lower interest rates andan increasing cost of insurance as the insured ages meant that formany policies, the cash option was diminished or depleted.
  • Variable universal life Insurance (VUL) is not the same as universallife, even though they both have cash values attached to them. Thesedifferences are in how the cash accounts are managed; thus havinga great effect on how they are treated for taxation.
  • Limited-pay - Another type of permanent insurance is Limited-paylife insurance, in which all the premiums are paid over a specifiedperiod after which no additional premiums are due to keep the policyin force. The most common kind of limited pay is twenty-year limitedpay. Another kind is paid-up when the insured is 65.
  • Endowments - Endowments are policies which the cash valuebuild up inside the policy, equals the death benefit (face amount)at a certain age. The age this commences is known as the endowmentage. Endowments are considerably more expensive (in terms of annualpremiums) than either whole life or universal life because the premiumpaying period is shortened and the endowment date is earlier.
  • In the United States, the Technical Corrections Act of 1988 tightenedthe rules on tax shelters (creating modified endowments). Thesefollow tax rules as annuities and IRAs do.
  • Endowment Insurance is paid out whether the insured lives or dies,after a specific period (e.g. 15 years) or a specific age (e.g.65).
  • Accidental death - Accidental death is a limited life insurancethat is designed to cover the insured when they pass away due toan accident. Accidents include anything from an injury, but do nottypically cover any deaths resulting from health problems or suicide.Because they only cover accidents, these policies are much lessexpensive than other life insurances.
  • It is also very commonly offered as "accidental death anddismemberment insurance", also known as an AD&D policy.In an AD&D policy, benefits are available not only for accidentaldeath, but also for loss of limbs or bodily functions such as sightand hearing, etc.
  • Accidental death and AD&D policies very rarely pay a benefit;either the cause of death is not covered, or the coverage is notmaintained after the accident until death occurs. To be aware ofwhat coverage they have, an insured should always review their policyfor what it covers and what it excludes. Often, it does not coveran insured who puts themselves at risk in activities such as: parachuting,flying an airplane, professional sports, or involvement in a war(military or not).
  • Accidental death benefits can also be added to a standard lifeinsurance policy as a rider. If this rider is purchased, the policywill generally pay double the face amount if the insured dies dueto an accident. This used to be commonly referred to as a "doubleindemnity" coverage.

Life Insurance Tips:

• Know what you need: The classic and best reason for an individualto buy life insurance is for protection against dying too soon. Theperson buying life insurance should be primarily concerned with seeingthat his or her survivors do not face a financial handicap. There maybe other reasons that apply: Life insurance is also purchased to payestate taxes. Business relationships often require life insurance orcan benefit from it, for example. Annuities offer a secure way for consumersto make sure they don't outlive their money. Beware of anyone who triesto sell you life insurance as an "investment." Life insuranceshould be purchased for the protection it will give you.
• Term life insurance: Most consumer advocates feel that terminsurance is the best life insurance buy. Term is different from "wholelife" or "ordinary life" in that you build up no equity,or cash value. In term, you pay each year for the cost of insurance,which typically increases annually as your chances of being alive thenext year decline. Most term policies are renewable on an annual basis,and some have level premiums or a decreasing death benefit for a statedperiod -- one, five or ten years, or even to a specified age.
• Whole life insurance: Whole, or "ordinary," lifeinsurance is usually sold with a level premium. In the early years ofthe policy, the annual premium will be higher than comparable term insurance.(But because its premiums are level, whole life's annual premiums mayeventually be less than term.) Whole life policies build up a cash valuethat consumers can withdraw or borrow against. There are many variationsof whole life. Premiums may be payable for a specified number of yearson a limited-payment basis. Consumers also may have the option of asingle premium — paying all of the premiums at once with a singlelump sum.
• Know the company you are buying from: You can check the financialstability of any life insurance company through several reputable nationalrating companies. Some ratings are available at public libraries. TheCommissioner's staff can verify that a company is authorized to do businessin Washington state, and you can also check here to see what kind ofcomplaints have been filed by other consumers against a company. Informationon ratings, complaints and licensing is available from CommissionerKreidler's toll-free Hot Line at 1-800-562-6900.
• Accelerated benefits: Under rules adopted by Insurance Commissionerin 1994, authorized Washington life insurers can issue policies thatinclude the possibility of accelerated benefits. Under these rules,a consumer suffering from a terminal illness can opt to receive discountedbenefits prior to death.
• Shop around for rates: Life insurance is a competitive marketplace,and much of the competition focuses on price. Don't hesitate to seekpremium quotes from several different companies.
• Shop for your own needs: If term insurance fits, that's whatyou should shop for. If you want to lower your premium at all costs,you may want to consider using a direct writer — a company thatcuts costs by operating without agents.
• Consider your own convenience, however: Do you want personalcontact with an agent? Or if you buy an annuity, how fast can you getto your money in case of an emergency? If you are buying whole life,how fast does your money accumulate? What will the cash value be inone year? Three years? Ten years?
• Update your coverage as your circumstances change: Don't bemisled by someone who tells you you should buy additional policies forchildren as they are born. Children rarely have an income and seldomrequire life insurance. But your situation may change dramatically fromyear to year. Review your net worth every few years and reconsider theprospects your survivors may face if you die.
• Don't let yourself get fast-talked into changes: Some lifeinsurance policyholders in recent years have fallen victim to a practicecalled "twisting" or "churning." Churning occurswhen your coverage is changed only to benefit the seller even thoughyou may suffer a loss in the process. Churning often happens when peoplewith cash-value policies are persuaded to convert their coverage toanother policy, often one with a promise of better benefits. The problemis that the cash value of the original policy is raided in order topay for the new policy. Luckless consumers may not realize until yearslater that the "higher" benefit policy is actually worth onlya fraction of the value of the original policy.
• Never buy a policy you don't understand: If you are given illustrationsor booklets, save that material with your policy. If your agent or companycannot explain the policy terms to your satisfaction, shop elsewhere.Make sure you understand the guarantees in your policy (not just theagent's promises of returns) and the surrender penalties if you chooseto drop the policy at any time. These costs are often hidden in a lifeinsurance or annuity policy.

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